Tom Connor's Thinking Forward A Little Ado About Moats by wuyunyi


									                               Tom Connor's Thinking Forward:

                                          A Little Ado About Moats
                                         (or, Buying New Batteries)

In days of old when Knights were bold, life could be tough. As a matter of fact the rich and
powerful built castles and moats to protect themselves and their valuables.

But as they built stronger castle walls and wider moats, their adversaries responded to the
challenge. Today the utility of these moats is mostly as scenery. But, the story of moats
and the protection they provide isn’t over.

People still build defenses today. In the world of business these are economic moats. Just
as the defenses in the ‘old’ days would be attacked and new ones developed, so today firms
respond to challenges and new moats are created that defend competitive advantage.

Today, much of the world’s economy is being transformed by the computer industry and
what has been called the Internet economy. The Center for Research in Electronic Com-
merce at the University of Texas at Austin has compared it to the Industrial Revolution “in
potential scope and size”.

       “Rapid advances in Internet technologies and the subsequent proliferation of eco-
       nomic activity on the Internet have ushered in an information age where virtually
       every organization is trying to position itself to take advantage of this new
       phenomenon. These economic developments involving the use of the Internet as an
       important business driver are collectively being referred to as the digital or the
       Internet economy1”

With innovations of the scope projected above it seems justified to also expect the develop-
ment of new and possibly different moats to protect returns and investments in the
‘information age’.

R.I.P. Adam Smith

Adam Smith described competitive markets and the role of prices in the movement and re-
allocation of economic resources in “The Wealth of Nations”. An extraordinary accomplish-
ment given many of us forget that prior economic systems relied on different mechanisms to
direct resources, not prices. One of these systems more recent to Adam Smith was feudal-
ism, and not many people today want to go back there. (Ask a serf.)

Recognizing that life in our world is a bit more complex, Smith’s exposition has held up
remarkably well. The movement from a feudal economy into one driven by markets has
seen an unprecedented development and growth of world income. New channels and tech-

  Measuring the Internet Economy: An Exploratory Study, Center for Research in Electronic Commerce,
Graduate School of Business, The University of Texas at Austin
           No aspect of this paper, in part or in whole, may be copied, reproduced or used in any form,
      electronic or otherwise, without the express written authorization of Tom Connor or NextStage Global

nologies like the Internet can be a difficult transformation, but one that also contains
opportunities. And as economies move from less to more developed there are also changes
in the nature and behavior of the economy.

One of Adam Smith’s critical assumptions was about human behavior. He assumed informa-
tion was sufficient to the decision-making needs of the players in the system, and that their
behavior was rational, that is, they acted in their own self-interest and had sufficient
information to do so. His focus was not to deal with differences in human behavior, but to
understand the way price directed resources in a market based economy. To Smith, human
behavior was a constant with people assessing adequate information and behaving in their
own self-interest.

In the Internet Age the amount of information and our ability to access it is making great
leaps, and we know more about how we make decisions. Herbert A. Simon, the 1978 Nobel
laureate economist, expresses concern this way: "What information consumes is rather
obvious: it consumes the attention of its recipients. Hence a wealth of information creates a
poverty of attention, and a need to allocate that attention efficiently among the over-
abundance of information sources that might consume it.''2

A summary of Simon’s work provides perspective: “Classical economists had argued that
people make rational choices to obtain the best commodity at the best price. Dr. Simon said
that was impossible -- too many choices and too little time to analyze them cause people to
choose the first option that is good enough to meet their needs.”3

Simon goes on to put this perspective on decision-making into the context of the larger
firms that we experience today. The comments by the Nobel committee reflects his view:

       “However, the rudimentary theory of the firm to be found in traditional economics
       was designed only to serve as a basis for studies of the total market behaviour and
       not of the behaviour of the individual firms. As long as these firms consisted of small,
       family-owned, patriarchally run units, and the price competition was fierce, their
       activities remained relatively uninteresting. However, as companies grew in size, as
       their activities eventually spread out beyond the national borders, as running them
       became separated more and more from owning them, as employees began to form
       labour unions, as the rate of development increased and as price competition
       between many was replaced by competition with regard to quality and service
       between few, the behaviour of the individual companies took on quite a different kind
       of interest. Thus, with time, the study of the structure and the decision-making of
       the firm became an important task in economic science. It is in this new line of
       development that Simon's work has been of the utmost importance.”4

One result in today’s firms has been the development of information to assist decision-
making. Since the larger firms we experience today bring with them higher capital and
other requirements, requirements far beyond those of industry in Adam Smith's day, there
is more attention to these issues. One measure of the strength of a firm’s competitive
advantage is the Return on Invested Capital (ROIC). Many consider it a measure of a firm’s
competitive advantage – its moat.5
  Computers, Communications and the Public Interest, pages 40-41, Martin Greenberger, ed., The Johns
Hopkins Press, 1971
  Herbert Simon, obituary;
  Nobel Committee Presentation Speech
  A common financial measure of economic moats is the Return on Invested Capital (ROIC). This is a
measure of how effectively company’s use the money (borrowed or owned) invested in its operations. A
           No aspect of this paper, in part or in whole, may be copied, reproduced or used in any form,
      electronic or otherwise, without the express written authorization of Tom Connor or NextStage Global

Moats Today

Moats can be short lived or long lived. The Palm Pilot PDA had technology that looked able
to provide a strong competitive advantage6, but as potential competitors realized the strong
profit potential they began to develop their own technology.7 lists SONY, Palm,
Hewlett-Packard, Casio, Compaq, Toshiba, Handera, and Kocera as PDA competitors. Com-
petitive advantage isn’t just the development of new technology.

Size isn’t a guarantee of competitive advantage either. The US auto industry has trans-
formed slowly. After an initial stage where producers were numerous, the industry con-
solidated to 3 firms. Sometime in the 1960’s international competition began, and now, at
this writing in November 2005, there are rumors that General Motors may declare

However, as professional management increases attention on the use of the firm’s resources
has improved. Today measures such as the ROIC indicate how well the firm is using it’s
capital, or how large the moat around the firm is. People are still making moats and build-
ing castles with high walls.

Types of Economic Moats

This summary of moats below is based on the description used by Morningstar8. The four
categories are ‘Low Cost Producer’, ‘High Switching Costs’, ‘The Network Effect’, and
‘Intangible Assets’.

Low Costs: High entry costs (often called barriers to entry) can bar competitors from joining
an industry. In the early days when producers were numerous entry costs were low. When
Ford automated production in 1914 the large scale of production raised costs and they
became a barrier. Ford’s competitive advantage lasted about 20 years when survivors in
the industry had learned how to run an assembly line. By then General Motors had shifted
the competitive advantage by utilizing flexible procedures that allowed them to deliver fre-
quent updates to their automobile styles. The industry came to be dominated by 3 major

Moats continued to evolve. During the 1960s international competition in the automobile
industry grew as other countries recognized the national advantages to their economies
from the development of a large industry like the auto industry. While the size of the firms
is still large, it has become one of lower ROICs and it remains very competitive.

Firms with similar advantages today include Dell Computer where its dominant position
allows it to negotiate advantageous terms from suppliers, and its sales-distribution system
is renowned. Walmart has also been able to achieve significant cost advantages from sup-
pliers helping fuel their growth and expansion, strengthening the advantage.

High change/switch cost for customer: products customers can’t get elsewhere. The com-
puter industry is an example where customers can’t get some products elsewhere. In the

simple formula is:
 Net Income After Tax / Invested Capital = After Tax Operating Earnings / (Total Assets - Excess Cash -
Non-Interest-Bearing Current Liabilities);
  Palm Pilot,
  The Motley Fool, Shaking Palm’s Hand Good-bye;
  How Morningstar Measures Moats;,3651,91441,00.html
            No aspect of this paper, in part or in whole, may be copied, reproduced or used in any form,
       electronic or otherwise, without the express written authorization of Tom Connor or NextStage Global

industry’s early day’s hardware vender's each had their own, proprietary operating systems
along with the applications that ran on those proprietary systems, making it difficult for
customers to switch to a competitor’s product. Switching meant the expense of new soft-
ware, hardware, and the training of staff. (Although applications could be the same, people
needed training in the style and interface of the new software and hardware as well at its
proprietary operating system.)

Database vendors experience a similar situation today. Users make significant investments
when purchasing database software, training staff, and developing company systems with
database embedded. Changing venders is a cost far beyond the price of new database soft-

Network economics: probably the biggest example is eBay, the online auction market. The
dominant size of eBay is a combination of its early entry into this market combined with its
success. New competitors would have a significant disadvantage competing with the size of
the market eBay provides users, both sellers and buyers. The size of their network is a dis-
tinct advantage to those offering products for sale, or those looking for products, something
difficult for newcomers to achieve.

Intangible Assets: assets that are not physical. These can include copyrights, patents,
intellectual property, brand identification, goodwill, and possible management. Drug com-
panies are among the most common examples of a moat from patents. But don’t forget
Post-it notes9, the glue patented by the 3M corporation that eventually achieved a use not
intended during its development, and the creation of a new market for 3M.

Jack Welch, former CEO of General Electric, has identified the corporate culture of GE as one
of that very successful company’s strengths. With the strategic focus established by senior
management, having a corporate culture that understands and implements that strategy
tenaciously is part of the overall advantage in the company.

Brands are another intangible asset. Coca-Cola, Gillette (now part of Proctor and Gamble)
are recognized brands worldwide, often because of great effort on behalf of the company.
But many consumers recognize and are comfortable brands, presenting a significant
obstacle to competitors new to their industry.

Moats for an Information Rich Economy

From Simon we have seen that behaviors are important in the economy. Herbert Simon
introduced the concept in his analysis of management behavior, but we can’t help but con-
sider that consumers encounter the same issues of information overload (poverty of atten-
tion) and the need to use that attention efficiently, and wonder how the Internet economy
will deal with individual consumers and their choices.

The University of California’s Berkeley's School of Information Management and Systems
has estimated the amount of information stored on the Internet.

            "In 2000 we estimated the volume of information on the public Web at 20 to 50
            terabytes; in 2003 we measured the volume of information on the Web at 167
            terabytes - at least triple the amount of information. The surface web is about 167
            terabytes as of Summer 2003; BrightPlanet estimates the deep web to be 400 to 450
            times larger, thus between 66,800 and 91,850 terabytes.”10
  Post-itNotes, 3M;
   UC Berkeley's School of Information Management and Systems; How Much Information? 2003
          No aspect of this paper, in part or in whole, may be copied, reproduced or used in any form,
     electronic or otherwise, without the express written authorization of Tom Connor or NextStage Global

The number of worldwide users accessing this information is also impressive. In 2005 estimated the number of Internet users worldwide at 15.0 % of the
worldwide population. However, in North America this reaches a high of 223,971,489 users,
or 68.2 % of the population. 11 The impressive gain in information and people’s access to it
re-emphasizes the importance of the decision making process. The OECD has also docume-
nted the adoption and use of the Internet among its member countries.

Simon has pointed out implications for professional management when there is “a wealth of
information”. But consumer choices will be affected by the same behavior. Optimal deci-
sions may not be those expected in the classical sense, instead given the abundance of
information and constraints of time other factors may well influence decisions.

Dead Batteries

Allow a personal story. When driving home recently I was near a store where I could buy a
rechargeable battery for a cordless phone. The clerk was unable to identify the battery with
the phone brand and model information I had. Darn. After returning home to retrieve that
information it was just much simpler and faster to search online. (Within .09 seconds
Google returned 23,300 results from my search for a Panasonic KX-36 re-chargeable bat-
tery.) Using the Firefox browser I opened about 12 links from the search page and reviewed
the options.

The shopping experience impressed me, but not well. I’m satisfied with the battery. With
shipping it cost a couple of cents less than driving back to the store for the purchase and it
was convenient, perhaps 20 minutes of time as opposed to driving at least 10 miles, etc.
Possible missed marketing opportunities impressed me.

Knowing that many in marketing recognize the most expensive sale is the first, and that
subsequent sales usually cost about 10% of the first it surprised me to realize I don’t know
the name of the company except for a vague recollection that the word battery was probably
in it. And, I don’t remember much about its web site. Compared to supermarket shopping
experiences where decisions are influenced by research results that develops techniques to
increase sales and build brand recognition with product displays, shelf placement, organiza-
tion of the store itself among others, more can be done.

The most recent Annual E-Commerce Report12 from ForeSee Reports states that customer
satisfaction from online e-commerce has declined after several years of strong growth.
Given the expectation from E-Commerce (forecasts of increased sales, increasing advertising
on the Internet, etc.) it surprises that more firms aren’t developing moats for their Internet
presence. Although retail battery sales are not the largest on the Internet it doesn’t take
much thought to realize at least several hundred family dollars are spent on batteries
among 5 or 6 family members. (And that doesn’t include batteries for the kids this holiday

Now shift into other spending categories, banking, brokerage, insurance, travel, let alone
the retail sector among others. E-Commerce does not have significant high entry costs or
geographic restrictions. The ForeSee report concludes that customer satisfaction is falling
as the e-commerce industry matures. “Sites that remain stagnant, or are unable to differ-
entiate themselves from the competition, eventually see customer satisfaction erode.” 13
   INTERNET USAGE STATISTICS - The Big Picture World Internet Users and Population Stats;
   Annual E-Commerce Report, Feb 2005;
   Annual E-Commerce Report, page 2, Feb 2005;
            No aspect of this paper, in part or in whole, may be copied, reproduced or used in any form,
       electronic or otherwise, without the express written authorization of Tom Connor or NextStage Global

Yet, in an Information Rich economy consumer decision-making is more than the evaluation
of the terms of trade and more than customer satisfaction. Understanding consumer deci-
sions depends on an understanding of consumer behavior. This is not the same as Adam
Smith’s ‘rational’ decision, but in the Information Rich economy of today far more relevant.
In a study that correlated the online success of a software company’s partners with
measures of customer trust the four most successful partners were also the four partners
whose online presence ranked highest in measures of trust.14

Does that say moat?

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